Real Estate Investors Are Just Monkeys

by Joe Stampone on August 18, 2010

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A few weeks ago there was an interesting conversation going on in the CRE blogosphere about the mindset of real estate investors. I have little to add to the exhaustive discussion, but I wanted to pass along the great insight. John Reeder over at Marketwi.se believes that real estate investors are all just monkeys. What exactly does he mean by that? Well, he outlined a common scenario:

Market is rising, investor is buying.  Market stops rising, investor is not worried.  He has income in place from the real estate.  Market starts falling, investor doesn’t think about selling.  He decides to wait it out for prices to come back.  That income is still in place.  Prices keep falling.  Tenants start to vacate.  Loans come due.  Investor can’t service the debt burden.  Investor loses the whole deal.

This is certainly a scenario that we see played out all the time, however left out is the option of small losses. How can that be? Now this is where it gets interesting. The guys over at CRE Console site an actual MIT study on real estate investor psychology which backs John’s original instinct.

This year, Sheharyar Bokhari & David Geltner, members of MIT’s Real Estate Research Institute, published a paper titled Loss Aversion and Anchoring in Commercial Real Estate Pricing: Empirical Evidence and Price Index Implications. (Access the entire study for free on PREA.org.)

So what did the study find?

We find that loss aversion plays a significant role in the behavior of investors in commercial online prescription drugs real estate. Interestingly, the strength of loss aversion behavior among commercial property market participants is actually greater among “institutional” investors (REITs, pension funds, foreign investors) than among smaller private investors (RCA’s “private in-state” category). Contrary to what one might expect and some previous studies have found in other fields, loss aversion pricing appears to be greater among sellers who have more experience in the commercial property market as indicated by their number of deals in the RCA database.

Now this may be counterintuitive, but it makes sense when you think about it. John made some great comments in response to the MIT study. Here’s how he explained this phenomena:

If I am an institutional investor, I am probably going to come up with an investment theme, find some data to back it up, present the theme and the underlying data to an investment committee.  The same material will also have to be presented to limited partners that will include private equity groups or pension funds.  Those limited partners will also have an investment committee, along with advisors.  If you add up all of the analysts, executives, advisors and committee members responsible for coming up with the investment theme and then approving it, it usually includes a bunch of really smart people.  On an individual deal basis you have a similar though more specific process that again requires the sign off from a bunch of really smart people.

The problems usually arise when the investment starts to tank.  It’s difficult to get really smart people to admit that they f—ed up.  Having more really smart people involved in the process doesn’t help if the goal is to quickly realize the mistake and then change course.  If I’m a general partner, I don’t want to tell my limited partners that I’ve lost their money.  If I’m an advisor to the limited partners, I don’t want to tell them that I advised them to place their capital with a GP that lost it.  If I’m an executive with a pension fund, I don’t want to admit that I was wrong and potentially get canned. Admitting that the investment is tanking early on means admitting you were wrong.  It’s easier to say “Hold tight, we’re going to ride this one out.”

I think there’s also another more subtle reason that investors choose to avoid small losses (hoping to turn it around, but willing to risk ruin in the process).  Real estate investing is built on mythology.  Some investors are sainted over time if they get enough calls right.  Names like Zell and Sternlicht are revered in real estate circles.  Every investor believes in the back of their mind that they have the talent to be those guys.  But admitting to your limited partners that you’ve lost some of their money isn’t going to get you to that level.  It’s only going to make it more difficult to raise the next fund, which is only going to make it more difficult to become the next Barry Sternlicht.

From my perspective, this makes perfect sense. Real estate investors are an optimistic bunch and it must be extremely difficult to pour so much work into a project and take a small loss because you think the value of the property is going to decline to a point where you can’t service the debt.

However, the best real estate entrepreneurs don’t perceive themselves as great risk takers, but instead as risk managers. In fact, they believe, whether right or wrong, that they can calculate and deal with the many inherent risks in most real estate projects. A key skill to being a good real estate professional is the ability to spot risks, develop strategies for coping with risks, and assess whether those strategies give you both enough protection and an adequate return. And if you’re wrong, it’s key to minimize the damage.

The guys over a Bay Area CRE also weighed in.

What do you think?

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  • http://www.astudentoftherealestategame.com/ Joe Stampone

    Here's a comment from my cuz Kev who was having issues posting comments. If anyone else is having trouble please let me know.

    Joe Stamp-

    Interesting blog post. I thought that the insight about good investors being “risk managers” as opposed to risk takers is spot on. I mainly hear the work “risk manager” talked about by executives with lots of capital markets responsibility, particularly in the hedge fund/ trading business. Applying that concept to less liquid assets classes, here real estate, seems to be inherently difficult because of that liquidity problem.

    While managing risk can be “easier” for traders or banks who have at their hands a wide array of vehicles and products which enable them to take counter positions to hedge their risk, or bet the other way, real estate investors have more limited options. This is particularly true for smaller investors. What other options do these real estate investors have to manage their risk except to sell the property that they believe will decline in value or income production? Obviously on a larger scale, managing risk mean engaging in transactions for which you are adequately capitalized, diversifying your investment portfolio across different types of real estate assets, in markets that are highly independent of one another, or a combination of different strategies. However, with regard to single positions taken in say, a large apartment building, managing that risk seems to mean knowing when to “cut your losses”. What other options are there to manage your risk?

    Kevin OB

  • http://www.creconsole.com CRE Console

    Great perspective. We do wonder, though, because few real estate investors are required to “mark-to-market” their assets every so often, Does this make it easier to try ride an investment out and hope the market gets better?

    For example, a property could generate the same amount of cash flow, but be worth 35% less than it was in 2008. Because the investment manager is still able to service the debt and pay quarterly distributions, there is little incentive to raise his hand and voluntarily tell his investors, the investment strategy didn't pan out.

    Add the fact that the same asset manager is collecting management fees for simply holding on to the asset, it begs the question, Is risk management to blame or is this a classic case of moral hazard?

    This could be another angle to the story. We're trying to find research which studies investment returns by investor type. We've seen it, just can't seem to locate it.

  • http://www.astudentoftherealestategame.com/ Joe Stampone

    Thanks for your comment and thoughtful analysis. Analyzing CRE investor historic psychology and putting it in today's market context is difficult, because we're in such unprecedented times.

    I agree with you; with banks encouraging borrows to “extend and pretend” or “delay and pray” whatever you want to call it, it incentivizes investors to to hold onto assets and wait for the market to return rather than admit they made a mistake. And how can you blame them.

    To me I think it's just a classic case of moral hazard. I'm surprised I haven't seen that term thrown around more, but that's exactly the case.

    I'd love to see the results of your study on investment returns by investor type.

  • http://www.astudentoftherealestategame.com/ Joe Stampone

    Check out John Reeder's follow-up post on his Marketwi.se blog – http://marketwi.se/2010/08/risk-managers/